Living Economics

Survival of the Fittest
In the PC business, low profit and generic products are compatible with market domination.

Dell Computer, the lowest-cost computer maker, emerged as the No. 1 Windows-based PC maker in the U.S. and the world during the biggest PC sale slump in 2001. Its price-cutting offensive lowered the prices of PCs and low-end servers by as much as 50% between September 1999 and July 2001. Even after aggressively slashing PC prices, it still managed to be the only profitable PC maker.

By cutting the gross profit margin1 from 21.3% in October to 17.5% in July 2001, it essentially has turned PC into a commodity business that competes on the basis of low cost. And with the operating margin2 at only 7%, Dell has little fat left for R&D in product innovation. At 1.5% of its revenues, its R&D expenditure is less than half of Compaq's 3.5%.

In textbook economics, an industry that sells generic products at low profit margin is usually characterized by many small firms. But in the generic PC industry, the number of competing firms are shrinking along with the profit margin and product variations. The reason for this phenomenon is that the PC competitors do not have identical cost structures. Dell's low cost arises from being a direct marketer with no middleman to dilute its profit. Its parts inventory is low because it makes to paid orders only, 50% of which are placed online. On average, there's just four days of stock in Dell's warehouses, compared to 24 days for Compaq. Because the price of chips, drives, and other parts typically falls 1% a week, Dell's low inventory allows it to take advantage of the latest low prices in components. It also enjoys bulk purchase discount as its market share expands. And it has no unsold inventory of finished products except for returned products. As long as cost falls faster than price, Dell is ahead of the game.

This business model is as easy to understand as it is difficult to copy for its competitors. Dell's low-price strategy has enabled its market share to increase 31% in the 12 months ended September 30, 2001 at the expense of Compaq, HP, and Gateway. Its domestic market share at 24.9% is almost twice as large as the next market rival, Compaq. And its CEO Michael Dell is aiming at 40% share in the US market.

But because the PC market is a mature business with low price elasticity of demand, a Credit Suisse First Boston analyst estimated that Dell's world market share must increase from 13% to 23% in two years just to prevent its profits from falling. Already, Dell has to lay off 5000 employees just to be in the black.

But price cutting, though good for consumers, is a dead-end business strategy for a market leader in a mature product. So Dell is pushing into network switches, computer services, and data storage where the profit margins are still much higher.

Thus, far from being the model of economic efficiency, low-profit and homogeneous products are the sign of an entropy state of dynamic market competition. And instead of having many small firms, only a few large firms may be left after all the excess capacity is eliminated.

Note:
  1. Gross profit margin is gross profit (gross of administrative and selling expenses) divided by net sales.
  2. Gross profit margin is gross profit (gross of administrative and selling expenses) divided by net sales.
  3. Operating margin is net profit divided by net sales.
  4. Operating margin is net profit divided by net sales.
References:
  • Boorstin, J. "Dell Does Domination." Fortune 01/21/02.
  • Park, A. et al. "Dell, the Conqueror." Business Week 09/24/01.
  • Sager, I. et al. "The Mother of All Price Wars." Business Week 07/30/01.
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